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Tax Changes In The Budget Deal

By John H. Schapiro

The huge Bipartisan Budget Act of 2015 passed by the House of Representatives on October 28 and by the Senate on October 30 – and probably signed by the President by the time this is posted – contains a few tax-related provisions of interest to a good number of our clients and others like them:

New Partnership Audit Rules.

The bill creates a new system for tax audits of partnerships, especially partnerships with over 100 partners. It could have a large effect on service businesses taxed as partnerships, like law firms, medical practices, engineering firms, and especially on private equity firms with dynamic ownership changes over time.

What we have had for several decades is a three-tier partnership audit structure. Very small partnerships, with 10 or fewer partners, could not be audited at the partnership level; all audits had to be of individual partners. Most other partnerships have been subject to audit under very cumbersome procedures that permitted a single partnership-level audit, but with lots of participation rights to individual partners, and all adjustments had to be made on amended returns of the individual partners for the tax year under audit. Partnerships with 100 partners or more could elect a more streamlined process, in which all adjustments were made at the partnership level and passed through to current partners at the time of the adjustment, not to the partners who were in place in the year under audit. Relatively few partnerships have made that election.

Under the new law, starting with tax years that begin on or after January 1, 2018, the default rule will closely resemble the current elective rule for large partnerships. Audits and adjustments will occur at the partnership level, including (as is not the case currently) the amount of taxes and penalties due. Current partners will generally bear the burden of the adjustments. There is a complex set of elections for taking into account differences in partner composition and tax law between the year under audit and the year in which the audit is being settled, and in some cases the partnership may be able to elect to have past-year partners file amended returns rather than passing through a settlement to current partners. Partnerships with 100 or fewer partners, with the partners consisting solely of eligible categories, can elect out of the new default rule, and have something like the current system for small partnerships apply to them. Most such partnerships will want to elect out of the new rules. This system – assuming it goes into effect in two years without changes – will substantially increase the ease of auditing partnerships (and entities like LLCs that are taxed as partnerships) that do not or cannot elect out of the new default rule, and it will make current partners liable for the sins of past partners in a way that has not been the rule to date.

Family Partnership Provision.

Some taxpayers have argued that Internal Revenue Code provisions regarding family partnerships require that children who receive family limited partnership interests as gifts be respected by the IRS as partners in a partnership even if under general tax principles the partnership would be disregarded as a sham or the specific partner not recognized as such.The budget bill inserts language in the Code to clarify that general tax principles apply to determining who are partners in a family limited partnership, and to whether the partnership should be recognized at all. We do not expect this to have any effect on our estate planning clients and their family entities.

Social Security Benefits – Goodbye to File and Suspend.

Many of our clients over age 65 and married, with a spouse close in age to them, have benefited from a strategy called “file and suspend” for their Social Security retirement benefits. One spouse, not yet 70, would file for social security benefits when his or her spouse was 66, then request immediate suspension of all benefits until the applicant’s 70th birthday. Meanwhile, the other spouse would file for a spousal benefit based on the first spouse’s account. The second spouse would get that spousal benefit, but both spouses’ primary benefits would continue to grow until they reached age 70. In effect, there could be up to four years of “free” spousal benefits.

No more. That loophole will be closed, effective six months from the signing of the new law. Couples will not be permitted to receive spousal benefits and to have their prospective benefits continue to grow larger.

People who have already adopted file and suspend will not be affected, and people where the younger spouse turns 66 within the next six months still have a chance to get this meaningful benefit.

For more information on how the tax changes in the budget deal could effect you or your business, contact  John Schapiro at jschapiro@kleinbard.com or 215.496.7234.